Help with finance's linguistic gymnastics

MARTIN HAWES
Last updated 14:20 06/08/2012
financial linguistics
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CONFUSING: Some financial terms are used interchangeably by those in the know, adding to confusion for the average punter.

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One of the problems with finance is the language. To understand finance is as much about learning a new language as anything - a language which, because it has little consistency, makes Swahili look easy.

Such is the language of finance that we find shares are called stocks in the United States but stocks are called bonds in Australia.

Government bonds are called gilts in Britain but called treasuries in the US and may be called stock or fixed interest in New Zealand.

These terms are all used interchangeably by those in the know.

Confused? No wonder, then, that a couple of months ago, a client looked at me rather sheepishly and asked quietly: What is a bond?

It is a good question and hats off to the client for fronting up with it honestly. I explained to the client a bond was an investment that paid an agreed rate of interest for an agreed period of time (often five years or more).

Bonds sound such secure investments that it seems you could never lose money on them - what language could you use that sounds safer than "bond"? Nevertheless, bonds do have risks: the issuer may go broke and so never pay interest or return your capital.

In addition, as I have said before on these pages, bonds are volatile - they not only rise and fall in value as the credit rating of the issuer changes, but also as prevailing interest rates change.

For example, at the moment if you purchased a US 10-year government bond (usually called a 10-year treasury), you would get an interest rate of 1.56 per cent. If interest rates rise, you are either stuck with that very low interest rate or you can sell the bond at a lower price to give the new investor a higher interest rate.

Either way, you would be in a lousy position.

The best way to understand this change in value is to understand the idea of a "coupon" and a bond's yield (more jargon).

The coupons are the interest payments that were agreed when the bond was issued (often paid every six months).

On the walls in my house I have a framed collection of old bonds including some Nazi bonds, Confederate bonds and quite a few corporate bonds for Chinese railways, Indian coal, US candy companies and the likes.

These bonds have little coupons attached (like the coupons for discounts at a supermarket) which people used to cut off on the due date and take to their bank to cash in. A 10-year bond that was originally issued for $1000 at 5 per cent for 10 years would have 20 coupons each worth $25. Every six months you could take one of the coupons to your bank and redeem it for cash until they were all gone (at which time the issuer of the bond gave you your $1000 back).

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If, after two years, you wanted to sell the bond, the potential buyer was effectively buying the remaining coupons plus the expectation of receiving the capital repayment of $1000 in eight years.

What those coupons and the return of capital were worth would depend on the buyer's assessment of the likelihood of all the coupons and the return of the capital being paid, and the interest rate for alternative bonds at the time.

If the buyer could buy the bond cheaply (say for $900) that would be a loss for the original investor.

However, the new investor would not only get the coupon payments but also on maturity get the full $1000. By buying the bond cheaply, the new investor gets a higher yield - the discount of $100 would increase the yield to maturity to 6.6 per cent.

So, the coupon is the amount of interest that was originally agreed but yield is the total return on the funds used to buy the bond.

For the first buyer, the yield and coupon rate are both the same at 5 per cent; for the second buyer, because he has bought cheaply, the yield is 6.6 per cent.

I have an ongoing reminder that bonds do have risks: most of my collection of old bonds still have the coupons attached because they were never paid (the Confederates and the Nazis lost their respective wars and did not pay; I guess the railways, coal and candy companies also failed to pay).

They now have a value only as collectors' items - whatever the language, some bond investors somewhere lost money.

- Martin Hawes is an authorised financial adviser and his disclosure statement is available free of charge at martinhawes.com. This article is of a general nature and no substitute for personalised financial advice.

- © Fairfax NZ News

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